Oil markets hold their ‘flag shape’ for the moment, as recession risks mount

Oil markets can’t quite make up their mind as to what they want to do, as the chart confirms. The are trapped in a major ‘flag shape’.

Every time they want to move sharply lower, the bulls jump in to buy on hopes of a major US-China trade deal and a strong economy. But when they want to make new highs, the bears start selling again.

Its been a long journey  for the flag, stretching back to the pre-Crisis peaks at nearly $150/bbl in the summer of 2008. And the bottom of the flag was made back in 2016, after the last collapse from 2014 $115/bbl peak.

Recent weeks have seen the bulls jump back in, when prices again threatened to break the flag’s floor below $60/bbl. And, of course, OPEC keeps making noises about further output cuts in an effort to talk prices higher.

But as the charts from the International Energy Agency’s latest monthly report confirm:

“The OPEC+ countries face a major challenge in 2020 as demand for their crude is expected to fall sharply.”

This is OPEC’s problem when it aims for higher prices than the market will bear. Other producers, inside and outside OPEC, always take advantage of the opportunity to sell more volume. And once they have spent the capital on drilling new wells, the only factor holding them back is the actual production cost.

Capital-intensive industries like oil have always had this problem. They raise capital from investors when prices are high – but high prices naturally choke off demand growth, and so the new wells come on stream just when the market is falling. Next year the IEA suggests will see 2.3mbd of new volume come on stream from the US, Canada, Brazil, Norway and Guyana as a result.

OPEC’s high prices have already impacted demand, as the IEA notes:

Sluggish refinery activity in the first three quarters has caused crude oil demand to fall in 2019 for the first time since 2009.”

OPEC has had a bit of a free pass until recently, though, in respect of the new volumes from the USA. As the chart shows, the shale drilling programme led to a major volume of “drilled but uncompleted wells”. In other words, producers drilled lots of wells, but the pipelines weren’t in place to then take the new oil to potential markets.

But now the situation is changing, particularly in the prolific Permian basin region, as Argus report:

“The Permian basin has been a juggernaut for US producers, with output quadrupling from under 1mbd in 2010 to more than 4.5mbd in October.  US midstream developers have responded with a wave of new long-haul pipelines to shuttle the torrent of supply to Houston, Corpus Christi and beyond.

“The 670kbd Cactus 2 and the 400kbd Epic line went into service in August moving Permian crude to the Corpus Christi area. Phillips 66’s 900kbd Gray Oak pipeline is expected to enter service this month, moving Permian basin crude to Corpus Christi, Texas, for export.”

As a result, some of that oil trapped in drilled but uncompleted wells is starting to come to market. So if OPEC wants to keep prices high, it will either have to cut output further, or hope that the world economy starts to pick up.

But the news on the economic front is not good, as everyone outside the financial world knows.  Central banks are still busy pumping out $bns to keep stock markets moving higher. But in the real world outside Wall Street, high oil prices, trade wars, Brexit uncertainty and many other factors are making recession almost a certainty.

As the chart shows, there is a high correlation between the level of oil prices and global GDP growth. Once oil takes ~3% of GDP, consumers start to cut back on other purchases. They have to drive to work and keep their homes warm in winter. And with inflation weak, their incomes aren’t rising to pay the extra costs.

The US sums up the general weakness.  The impact of President Trump’s tax cuts has long disappeared. And now concerns are refocusing on the debt that it has left behind. As the function of debt is to bring forward demand from the future, growth must now reduce.  US GDP growth was just 1.9% in Q3, and the latest Q4 forecast from the Atlanta Fed is just 0.3% .

Its still too early to forecast which way prices will go, when they finally break out of the flag shape. But their failure to break upwards in the summer, when the bulls were confidently forecasting war with Iran, suggests the balance of risks is now tilting to the downside.

Oil market weakness suggests recession now more likely than Middle East war

Oil markets remain poised between fear of recession and fear of a US attack on Iran. But gradually it seems that fears about a war are reducing, whilst President Trump’s decision to ramp up the trade war with China makes recession far more likely.

The chart of Brent prices captures the current uncertainties:

  • It shows monthly prices for Brent since 1983 and highlights the conflicting risks
  • The bulls have been battling to push prices higher, but their confidence is weakening
  • The bears were hurt by the stimulus from US tax cuts and OPEC output cuts
  • But June’s abandonment of the Iran attack lifted their confidence

As a member of the President’s national security advisory team has noted:

“This is a president who was elected to get us out of war. He doesn’t want war with Iran.”

With fears about a potential war reducing, at least for the moment, attention has instead turned to issues of supply and demand.  And here, again, the balance of different factors has turned negative:

  • As the second chart shows, supply from the 3 major countries remains at a high level
  • The US is the largest producer, and August’s output is now recovering after the slowdown in the Gulf of Mexico due to Hurricane Barry, and the EIA is forecasting new record highs this year and 2020
  • 3 new pipelines are also coming online during H2, which will boost US oil export potential
  • Meanwhile Russia, as usual, has failed to follow through on its commitment to the OPEC cuts. Its output rose by 2% in January-July versus 2018, despite May/June’s contamination problems
  • As always with OPEC output cuts, Saudi Arabia has been forced to fill the gap. Its volume dipped to 9.8mbd in July, well below the 11mbd peak last November

Overall, global supply has remained strong with EIA estimating Q2 output at 100.6mbd versus 99.8mbd in Q2 last year. Contrary to last year’s optimism over global economic recovery, EIA suggests Q2 consumption only rose to 100.3mbd, versus 99.6mbd in Q2 last year.

And the normally bullish International Energy Agency last week cut its demand forecast for this year and 2020 warning:

“The outlook is fragile with a greater likelihood of a downward revision than an upward one…Under our current assumptions, in 2020, the oil market will be well supplied.”

The third chart, from Orbital Insight, highlights the changes that have been taking place in inventory levels in the major regions.

Generated from satellite images of floating roof tank farms, it is based on estimates of the volume of oil in each tank, which are then aggregated to regional or country level.

Oil markets are by nature opaque. But Orbital’s data does show a very high correlation with EIA’s estimates for  Cushing – where the official data is very reliable.

As discussed here many times before, the chemical industry is the best leading indicator for the global economy, due to its wide range of applications and geographic coverage.  The fourth chart shows the steady downward trend since December 2017 in the data on Capacity Utilisation from the American Chemistry Council.

Q2 has shown the usual seasonal ‘bounce’,  but key end-user markets such as electronics, autos and housing are also clearly weakening, as discussed last week for smartphones.  And Bloomberg has reported that US inventory levels at major warehouses are close to being full.

I suggested back in May that prudent companies would develop a scenario approach that planned for both war and recession, given that the outcome was then essentially unknowable.

Today, both scenarios are clearly still possible. But it would seem sensible to now step up planning for recession, given the downbeat signals from oil and chemical markets.

 

 

 

Recession risk rises as Iran tensions and US-China trade war build

Oil markets are once again uneasily balanced between two completely different outcomes – and one again involves Iran.

Back in the summer of 2008, markets were dominated by the potential for an Israeli attack on Iranian nuclear facilities, as I summarised at the time:

“Nothing is certain in life, except death and taxes. But it is hard to see markets becoming less volatile until either an attack takes place, or a peaceful solution is confirmed. And with oil now around $150/bbl, two quite different outcomes seem possible:

• In the event of an Israeli attack, prices might well rise $50/bbl to reach $200/bbl, at least temporarily

• But if diplomacy works, they could easily fall $50/bbl to $100/bbl”

In the event, an attack was never launched and prices quickly fell back to $100/bbl – and then lower as the financial crisis began.

Today, Brent’s uneasy balance around $70/bbl reflects even more complex fears:

  • One set of worries focuses on potential supply disruption from a war in the Middle East
  • The other agonises over the US-China trade war and the rising risk of recession

It is, of course, possible that both fears could be realised if war did break out in the Gulf and oil prices then rose above $100/bbl.

The issue is highlighted in the Reuters chart on the left, which shows that Brent has moved from a contango of $1/bbl at the beginning of the year into a backwardation of nearly $4/bbl on the 6-month calendar spread. As they note:

“Backwardation is associated with periods of under-supply and falling inventories, while contango is associated with the opposite, so the current backwardation implies stocks are expected to fall sharply.”

But as the second Reuters chart confirms, traders are also aware that forecasts for oil demand are based on optimistic IMF forecasts for global growth. And recent hedge fund positioning confirms that caution may be starting to appear.

Traders are also aware of the key message from the above chart, which shows that periods when oil prices cost 3% of global GDP have almost always led to recession.  The only exception was after the financial crisis when central banks were printing as much money as possible to boost liquidity.

The reason is that consumers only have a certain amount of discretionary income.  If oil prices are low, then they have spare cash to buy the products and services that create economic growth. But if prices are high, their cash is instead spent on transport and heating/cooling costs, and so the economy slows.

“To govern is to choose” and President Trump therefore has some hard choices ahead:

  • His trade war with China currently appeals to many voters, Democrat and Republican.  But will that support continue as the costs bite?  The New York Federal Reserve reported on Friday that the latest round of tariffs will cost the average American household $831/year
  • Similarly, many voters favour taking a hard line with Iran.  But average US gasoline prices are already $2.94/gal as the US driving season starts this weekend, and today’s high prices will particularly impact the President’s core blue collar and rural voters

History doesn’t repeat, but it often rhymes as the famous American writer, Mark Twain, noted. If the President now chooses to fight a trade war with China and a real war with Iran, then he risks losing popularity very quickly as the costs in terms of lives and cash become more apparent.  Yet as we have seen since Lyndon Johnson’s time, this is usually something that politicians only learn after the event.

Investors and companies therefore have little to lose, and potentially much to gain, by accepting that we can only guess at how the two situations may play out.  Developing a scenario approach that plans for all the possible outcomes – as in 2008 – is much the most prudent option.

Déjà vu all over again for oil markets as recession risks rise

Back in 2015, veteran Saudi Oil Minister Ali  Naimi was very clear about Saudi’s need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.

As Naimi recognised, high oil prices created a short-term win for Saudi’s budget between 2011-4.  But they also allowed US frackers to enter the market – posing a major threat to Saudi’s control – whilst also reducing overall demand.  And his “boss”, Crown Prince Mohammed bin Salman (MbS) agreed with him, saying:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil. We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

Today, however, Saudi oil policy has reversed course, with MbS now trying to push prices towards the $80/bbl level assumed in this year’s Budget.

Saudi’s dilemma is that its growing population, and its need to diversify the economy away from oil, requires increases in public spending. As a result, it has conflicting objectives:

  • Its long-term need is to defend its market share, to guarantee its ability to monetise its vast oil reserves
  • But its short-term need is to support prices by cutting production, in order to fund its spending priorities

The result, as the chart above confirms, is that prices are now at levels which have almost always led to recession in the past.  It compares the total cost of oil* as a percentage of global GDP with IMF data for the economy, with the shaded areas showing US recessions. The tipping point is when the total cost reaches 3% of global GDP. And this is where we are today.

The reason is that high oil prices reduce discretionary spending.  Consumers have to drive to work and keep their homes warm (and cool in the summer).  So if oil prices are high, they have to cut back in other areas, slowing the economy.

CENTRAL BANK STIMULUS MADE OIL PRICES “AFFORDABLE” IN 2011-2014

There has only been one occasion in the past 50 years when this level failed to trigger a recession. That was in 2011-14, when all the major central bank stimulus programmes were in full flow, as the left-hand chart shows.

They were creating tens of $tns of free cash to support consumer spending.  But at the same time, of course, they were creating record levels of consumer debt, as the right-hand chart shows from the latest New York Federal Reserve’s Household Debt Report.  It shows US household debt is now at a record $13.54tn. And it confirms that consumers have reached the end of the road in terms of borrowing:

“The number of credit inquiries within the past six months – an indicator of consumer credit demand – declined to the lowest level seen in the history of the data.

SAUDI ARABIA IS NO LONGER THE SWING SUPPLIER IN OIL MARKETS

Oil prices are therefore now on a roller-coaster ride:

  • Saudi tried to push them up last year, but this meant demand growth slowed and Russian/US output rose
  • The rally ran out of steam in September and Brent collapsed from $85/bbl to $50/bbl in December

Now Saudi is trying again. It agreed with OPEC and Russia in December to cut production by 1.2mbd – with reductions to be shared between OPEC (0.8 million bpd) and its Russia-led allies (0.4 million bpd).  But as always, its “allies” have let it down.  So Saudi has been forced to make up the difference. Its production has fallen from over 11mbd to a forecast 9.8mbd in March.

Critically however, as the WSJ chart shows, it has lost its role as the world’s swing supplier:

Of course, geo-politics around Iran or Venezuela or N Korea could always intervene to support prices. But for the moment, the main support for rising prices is coming from the hedge funds.  As Reuters reports, their ratio of long to short positions in Brent has more than doubled since mid-December in line with rising stock markets.

But the hedge funds did very badly in Q4 last year when prices collapsed. And so it seems unlikely they will be too bold with their buying, whilst the pain of lost bonuses is so recent.

Companies and investors therefore need to be very cautious.  Saudi’s current success in boosting oil prices is very fragile, as markets are relying on more central bank stimulus to offset the recession risk. If market sentiment turns negative, today’s roller-coaster could become a very bumpy ride.

Given that Saudi has decided to ignore al-Naimi’s warning, the 2014-15 experience shows there is a real possibility of oil prices returning to $30/bbl later this year.

 

*Total cost is number of barrels used multiplied by their cost

Oil prices flag recession risk as Iranian geopolitical tensions rise

Today, we have “lies, fake news and statistics” rather than the old phrase “lies, damned lies and statistics”. But the general principle is still the same.  Cynical players simply focus on the numbers that promote their argument, and ignore or challenge everything else.

The easiest way for them to manipulate the statistics is to ignore the wider context and focus on a single “shock, horror” story.  So the chart above instead combines 5 “shock, horror”  stories, showing quarterly oil production since 2015:

  • Iran is in the news following President Trump’s decision to abandon the nuclear agreement, which began in July 2015.  OPEC data shows its output has since risen from 2.9mbd in Q2 2015 to 3.8mbd in April – ‘shock, horror’!
  • Russia has also been much in the news since joining the OPEC output agreement in November 2016.  But in reality, it has done little.  Its production was 11mbd in Q3 2016 and was 11.1mbd in April- ‘shock, horror’!
  • Saudi Arabia leads OPEC: its production has fallen from 10.6mbd in Q3 2016 to 9.9mbd in April- ‘shock, horror’!
  • Venezuela is an OPEC member, but its production decline began long before the OPEC deal.  The country’s economic collapse has seen oil output fall from 2.4mbd in Q4 2015 to just 1.5mbd in April- ‘shock, horror’!
  • The USA, along with Iran, has been the big winner over the past 2 years.  Its output initially fell from 9.5mbd in Q1 2015 to 8.7mbd in Q3 2016, but has since soared by nearly 2mbd to 10.6mbd in April- ‘shock, horror’!

But overall, output in these 5 key countries rose from 35.5mbd in Q1 2015 to 36.9mbd in April.  Not much “shock, horror” there over a 3 year period.  More a New Normal story of “Winners and Losers”.

So why, you might ask, has the oil price rocketed from $27/bbl in January 2016 to $45/bbl in June last year and $78/bbl last Friday?  Its a good question, as there have been no physical shortages reported anywhere in the world to cause prices to nearly treble.  The answer lies in the second chart from John Kemp at Reuters:

  • It shows combined speculative purchases in futures markets by hedge funds since 2013
  • These hit a low of around 200mbbls in January 2016 (2 days supply)
  • They then more than trebled to around 700mbbls by December 2016 (7 days supply)
  • After halving to around 400mbbls in June 2017, they have now trebled to 1.4mbbls today (14 days supply)

Speculative buying, by definition, isn’t connected with the physical market, as OPEC’s Secretary General noted after meeting the major funds recently:  “Several of them had little or no experience or even a basic understanding of how the physical market works.”

This critical point is confirmed by Citi analyst Ed Morse:  “There are large investors in energy, and they don’t care about talking to people who deal with fundamentals. They have no interest in it.

Their concern instead is with movements in currencies or interest rates – or with the shape of the oil futures curve itself. As the head of the $8bn Aspect fund has confirmed:

“The majority of our inputs, the vast majority, are price-driven. And the overwhelming factor we capitalise on is the tendency of crowd behaviour to drive medium-term trends in the market.” (my emphasis).

OIL PRICES ARE NOW AT LEVELS THAT USUALLY LEAD TO RECESSION

The hedge funds have been the real winners from all the “shock, horror” stories.  These created the essential changes in “crowd behaviour”, from which they could profit.  But now they are leaving the party – and the rest of will suffer the hangover, as the 3rd chart warns:

  • Oil prices now represent 3.1% of global GDP, based on latest IMF data and 2018 forecasts
  • This level has been linked with a US recession on almost every occasion since 1970
  • The only exception was post-2009 when China and the Western central banks ramped up stimulus
  • The stimulus simply created a debt-financed bubble

The reason is simple.  People only have so much cash to spend.  If they have to spend it on gasoline and heating their home, they can’t spend it on all the other things that drive the wider economy.  Chemical markets are already confirming that demand destruction is taking place.:

  • Companies have completely failed to pass through today’s high energy costs.  For example:
  • European prices for the major plastic, low density polyethylene, averaged $1767/t in April with Brent at $72/bbl
  • They averaged $1763/t in May 2016 when Brent was $47/bbl (based on ICIS pricing data)

Even worse news may be around the corner.  Last week saw President Trump decide to withdraw from the Iran deal.  His daughter also opened the new US embassy to Jerusalem.  Those with long memories are already wondering whether we could now see a return to the geopolitical crisis in summer 2008.

As I noted in July 2008, the skies over Greece were then “filled with planes” as Israel practised for an attack on Iran’s nuclear facilities.  Had the attack gone ahead, Iran would almost certainly have closed the Strait of Hormuz.  It is just 21 miles wide (34km)  at its narrowest point, and carries 35% of all seaborne oil exports, 17mb/d.

As Mark Twain wisely noted, “history doesn’t repeat itself, but it often rhymes”.  Prudent companies and investors need now to look beyond the “market-moving, shock, horror” headlines in today’s oil markets.  We must all learn to form our own judgments about the real risks that might lie ahead.

 

Given the geopolitical factors raised by President Trump’s decision on Iran, I am pausing the current oil forecast.

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Saudi oil policy risks creating perfect storm for Aramco flotation

Good business strategies generally create good investments over the longer term. And so Aramco needs to ensure it has the best possible strategies, if it wants to maximise the outcome from its planned $2tn flotation. Unfortunately, the current oil price strategy seems more likely to damage its valuation, by being based on 3 questionable assumptions:

  • Oil demand will always grow at levels seen in the past – if transport demand slows, plastics will take over
  • Saudi will always be able to control the oil market – Russian/US production growth is irrelevant
  • The rise of sustainability concerns, and alternative energy sources such as solar and wind, can be ignored

These are dangerous assumptions to make today, with the BabyBoomer-led SuperCycle fast receding into history.

After all, even in the SuperCycle, OPEC’s attempt in the early 1980s to hold the oil price at around today’s levels (in $2018) was a complete failure.  So the odds on the policy working today are not very high, as Crown Prince Mohammed bin Salman (MbS) himself acknowledged 2 years ago, when launching his ambitious ‘Vision 2030:

“Within 20 years, we will be an economy that doesn’t depend mainly on oil.  We don’t care about oil prices—$30 or $70, they are all the same to us. This battle is not my battle.”

As I noted here at the time, MbS’s bold plan for restructuring the economy included a welcome dose of reality:

“The government’s new Vision statement is based on the assumption of a $30/bbl oil price in 2030 – in line with the long-term historical average. And one key element of this policy is the flotation of 5% of Saudi Aramco, the world’s largest oil company. Estimates suggest it is worth at least $2tn, meaning that 5% will be worth $100bn. And as I suggested to the Wall Street Journal:

“The process of listing will completely change the character of the company and demand a new openness from its senior management“.

MbS is still making good progress with his domestic policy reforms.  Women, for example, are finally due to be allowed to drive in June and modern entertainment facilities such as cinemas are now being allowed again after a 35 year ban.  But unfortunately, over the past 2 years, Saudi oil policy has gone backwards.

SUSTAINABILITY/RENEWABLES ARE ALREADY REDUCING OIL MARKET DEMAND

Restructuring the Saudi economy away from oil-dependence was always going to be a tough challenge.  And the pace of the required change is increasing, as the world’s consumers focus on sustainability and pollution.

It is, of course, easy to miss this trend if your advisers only listen to bonus-hungry investment bankers, or OPEC leaders.  But when brand-owners such as Coca-Cola talk, you can’t afford to ignore what they are saying – and doing.

Coke uses 120bn bottles a year and as its CEO noted when introducing their new policy:

“If left unchecked, plastic waste will slowly choke our oceans and waterways.  We’re using up our earth as if there’s another one on the shelf just waiting to be opened . . . companies have to do their part by making sure their packaging is actually recyclable.”

Similarly, MbS’s advisers seem to be completely ignoring the likely implications of China’s ‘War on Pollution’ for oil demand – and China is its largest customer for oil/plastics exports.

Already the European Union has set out plans to ensureAll plastic packaging is reusable or recyclable in a cost-effective manner by 2030”.

And in China, the city of Shenzhen has converted all of its 16359 buses to run on electric power, and is now converting its 17000 taxis.

Whilst the city of Jinan is planning a network of “intelligent highways” as the video in this Bloomberg report shows, which will use solar panels to charge the batteries of autonomous vehicles as they drive along.

ALIENATING CONSUMERS IS THE WRONG POLICY TO PURSUE
As the chart at the top confirms, oil’s period of energy dominance was already coming to an end, even before the issues of sustainability and pollution really began to emerge as constraints on demand.

This is why MbS was right to aim to move the Saudi economy away from its dependence on oil within 20 years.

By going back on this strategy, Saudi is storing up major problems for the planned Aramco flotation:

  • Of course it is easy to force through price rises in the short-term via production cuts
  • But in the medium term, they upset consumers and so hasten the decline in oil demand and Saudi’s market share
  • It is much easier to fund the development of new technologies such as solar and wind when oil prices are high
  • It is also much easier for rival oil producers, such as US frackers, to fund the growth of new low-cost production

Aramco is making major strides towards becoming a more open company.  But when it comes to the flotation, investors are going to look carefully at the real outlook for oil demand in the critical transport sector.  And they are rightly going to be nervous over the medium/longer-term prospects.

They are also going to be very sceptical about the idea that plastics can replace lost demand in the transport sector.  Already 11 major brands, including Coke, Unilever, Wal-Mart  and Pepsi – responsible for 6 million tonnes of plastic packaging – are committed to using “100% reusable, recyclable or compostable packaging by 2025“.

We can be sure that these numbers will grow dramatically over the next few years.  Recycled plastic, not virgin product, is set to be the growth product of the future.

ITS NOT TOO LATE FOR A RETURN TO MBS’s ORIGINAL POLICY
Saudi already has a major challenge ahead in transforming its economy away from oil.  In the short-term:

  • Higher oil prices may allow the Kingdom to continue with generous handouts to the population
  • But they will reduce Aramco’s value to investors over the medium and longer-term
  • The planned $100bn windfall from the proposed $2tn valuation will become more difficult to achieve

3 years ago, Saudi’s then Oil Minister was very clear about the need to adopt a market share-based pricing policy:

“Saudi Arabia cut output in 1980s to support prices. I was responsible for production at Aramco at that time, and I saw how prices fell, so we lost on output and on prices at the same time. We learned from that mistake.”

As philosopher George Santayana wisely noted, “Those who cannot remember the past are condemned to repeat it.”

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